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The Subtle Cruelty of Efficiency Wages

One of the more sophisticated arguments for minimum wage stems from the Efficiency Wages Hypothesis (EWH). The EWH asserts that firms will sometimes pay higher-than-market wages for their workers. These wages reduce turnover and increase productivity, making the wages more viable for the firms. However, it is important to note that with EWH, there is still unemployment in the industry: higher-than-equilibrium wages reduce quantity demanded and increase quantity supplied from the equilibrium point, creating a surplus of labor (unemployment).

Minimum wage activists will cite the EWH for reasons for the minimum wage, claiming the reduced turnover and increased productivity is a positive for the firms. That much is true. But howdoes the EWH increase productivity and reduce turnover? Workers may be feeling better with a higher wage, so they’ll naturally work harder. That’s possible. But the real reason is the cost of losing the job is now higher. With persistent unemployment in the industry, the threat of firing forces workers to work harder in order to keep their jobs (thus increasing productivity). Turnover is reduced not out of some sense of loyalty to the firm now paying higher wages but because there are fewer jobs available and they are being competed for by more workers!

In short, an Efficiency Wage (especially if legally mandated like the minimum wage) gives employers more power over workers; it reduces worker bargaining power and reduces worker ability to leave if conditions are unfavorable to them.

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12 thoughts on “The Subtle Cruelty of Efficiency Wages”

There is a similar phenomenon with union shops that create above-market compensation locks. My daughter is a teacher in California. The salary and benefits package after a few years of employment is far higher than what she could earn elsewhere. The school and the students may benefit from retaining her, but she points out that there are many, many teachers in the school who really ought to leave because they are no longer motivated or competent. Instead of doing so, they stay until retirement to collect benefits and put in the minimal effort required to retain their job (which because of the union, is VERY minimal) The school, students and parents are harmed because of this barrier to exit.

The EWH is like many politically correct arguments. It sounds good only if you look at the immediate effects and assume there will be no longer term effects from such legislation. But, that is not reality as you have clearly stated above.

You write that a company may hire people and pay higher-than-market wages that reduce turnover and increase productivity, making those wages more viable for the firm. In what sense are these wages “higher-than-market”? Isn’t the market determined by what companies are willing to pay and what workers are willing to accept?

The workers leave too often for efficiency if the company pays less. The workers would find employment at a higher wage, indicating that there is not high unemployment among those who would satisfy employers in this industry. The higher wage which reduces turnover and decreases overall costs must be the equilibrium wage.

Suppose that half of employers pay the higher wage for low turnover, while the other half pay a lower wage and tolerate more turnover. That certainly is an effect of differing management styles, and again these wages are in equilibrium, at least until almost all companies choose one style as the norm, and then the wages would be in equilibrium again.

Also, people differ in their abilities and conscientiousness. A higher wage would select for the more conscientious, and the company’s experience might be that keeping these better people requires a higher wage, even if the workers appear the same upon hiring.

Lacking superhuman powers, how would one know that the real equilibrium wage is different from the wage observed in the market? And, how would one conclude that the observed wage is somehow wrong and causing “unemployment”?

I am surprised. Usually, employers will not pay more than the value of what a person produces. You are saying overall that sometimes an employer will pay more than that to increase a worker’s efficiency and to reduce turnover

Case 1: “Good workers only”. After paying the higher wage and conserving on expensive training (low turnover), then the employee produces more than his wage. The employer noticed that lower wages keep only people who lose money for the company; their work product being less than their lower wage. So, the higher wage is the market wage, possibly the least wage which makes sense for the company.

Henry Ford did this explicitly. His assembly line could only be profitable if the error rate was very low. He paid twice the going rate for the most skilled and conscientious workers. He wouldn’t pay less or expect less.

Case 2: “Good workers are more profitable”. Employees avalable at the lower wage produce enough to justify that lower wage. But, more training and higher pay motivate employees to produce say 1.3 times more than the wage increase, and so this is more profitable for the company. This is the market wage for an insightful employer, offered to all good workers.

Case 3: “Even good workers are not enough”. A higher wage has good effects, but it is no use. Even the higher efficiency doesn’t produce enough to justify the higher wage, and lower efficiency is worse. So, there is no wage which is profitable. Such jobs would not exist.

I don’t see any hidden “work product wage” other than what is revealed by what employers offer. Employers will pay more to get more. It doesn’t make sense that there is some lower wage which would employ more people without denying a better result to both employer and employee. The higher “efficiency wage” is not blocking a move to a higher employment equilibrium which is better for everyone.

There is asymmetric information in the labor market. An employer hires a worker, but does not know how much they are shirking work. Further, if the market is at equilibrium, the worker knows if he is fired, there is another job waiting for him immediately, so his incentive to shirk is higher. His productivity is lower.

So, the employer offers higher-than-normal wages. If the employee shirks, he is fired, and he won’t be able to get as good a job elsewhere; his shirking has a real cost to it. if all employers do this, then there is unemployment in the market and the worker faces a harder job search, reducing his incentive to shirk.

You say first that information is asymmetric; the employer does not know if the employee is shirking. Then, that the employer fires those who are shirking. So, the employer comes to know after all. I don’t see a higher wage giving the employer more or less knowledge. I do see the higher wage as attracting and keeping employees who don’t shirk.

I don’t unnderstand what “higher than normal wages” means. What is normal, and why should wages return to a lower level? Isn’t efficiency and profit producing the incentive to offer a higher wage, as usual under competition?

I think you are splitting hairs. It is enough that the employer can determine if a worker is producing enough and fires those who don’t meet his standards. So, asymmetric information isn’t the reason for offering a wage which is higher than an economist thinks is reasonable.

The employer by unknown means (even just experimentation) finds that some employees respond to a demand and a raised wage by producing even more than the raise, so the employer offers that raised wage. A workable policy would be to hire based on resume’ and skill, offer the higher wage, and keep only those who rise to the higher productivity demanded by the employer. Of course, workers who meet that standard will not find a less demanding job which offers that wage. There may be many less demanding jobs in the same industry and with the same conventional qualifications at a lower wage.

The EWH to me is an elabortion of a special case. Economists are comfortable with the idea of paying more for such as longer hours, more education, and higher intelligence. Why are they uncomfortable with the idea that better concentration and time management is worth a higher wage? Why is this a special case requiring an “EWH Hypothesis”?

About the minimum wage. Many employers may be unable or unwilling to pay some people more who are doing “the same job”. Labor laws and antidescrimination laws interfere with offering different wages to workers who are “the same”, merely because the employer “thinks” that some are more productive than others. So, I think natural Efficiency Wages are suppressed in lower paying jobs. Then, if labor law forces employers to pay a higher wage to everyone, they will naturally hire only the most productive, leaving the less productive without any job. Or, they go out of business if there are too few who can be sufficiently efficient at any higher wage.

It is unreasonable to assume that forcing a higher wage will bring out greater productivity in most people who worked at the lower wage. That is like thinking that a higher wage will bring out greater intelligence in most people. That is the evil side of the EWH, and a side which I don’t think you support.